15 Dividend Stocks Trading Below Their Calculated Fair Value

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This is one of my all-time favorite Buffett quotes. In ten small words the entire philosophy of value investing is conveyed. The inherent message is that price and value aren't necessarily the same. This is how value investors make money in the stock market - buying stocks for less than their fair value.

When selecting dividend growth stocks, I take a value approach in determining the maximum price I can pay and still obtain my long-term target. The focus is on the investment's value derived from the future dividend stream generated by the stock.

Since I am looking at stocks differently than many other investors, I can often find value, as I have defined it, when others can not. Here is how I calculate Fair Value:

Fair Value PriceI use the Mid-2 Price and the NPV MMA Price when calculating the Fair Value Price of a stock. They are weighted depending on where we are in the cycle. Of the two, I consider NPV MMA Price the more important. We will look at how each is calculated below.

NPV MMA PriceThis approach considers two cash flows - one from a Money Market Account (MMA) earning a rate equal to a 20 year Treasury and a dividend growth stock. The value calculated is the net present value (NPV) of the difference between the annual dividend earnings of this investment and the interest income from the MMA over 20 years.

The NPV MMA target is determined based on the number of consecutive years of dividend increases. The formula is: Target = Base – (Years x Increment) + Minimum where Base=3,000, Increment=100, Minimum=500. Thus 0 years of dividend growth yields a $3,500 target and 30 years of growth yields a $500 target. The D4L-PreScreen.xls model can be used to calculate this number.

Mid-2 PriceThe Mid-2 Price is based on more traditional calculations. It considers four fair value calculations, Average High Yield Price, 20-Year DCF Price, Average P/E Price and Graham Number, the highest and lowest fair values are excluded and the remaining two calculations are averaged to calculate the Mid-2 Price.

The 20-Year DCF (Discounted Cash Flow) Price is calculated by taking the Net Present Value (NPV) of the next 20 years of dividends and the estimated value of the stock at the end of 20 years. See 20-Year-DCF.xls for an example of how this is calculated.

Average High Yield Price is calculated by dividing current dividend per share by the average high dividend yield price for each of the last 5-years (dividend per share divided by the year’s low share price).

Average P/E Price is calculated by multiplying the EPS (trailing twelve months) times the minimum of: 1.) 5-year average of high and low P/Es or 2.) Last years high P/E.

The Graham Number Price is calculated by taking the square root of 22.5 times the tangible book value per share times EPS (lower of trailing twelve months or average last 3 years).

Benjamin Graham, Warren Buffett's mentor and the father of value investing, developed rules for the defensively screening stocks. This formula uses his principles to calculate the "maximum" price one should pay for the stock.

Graham believed, as a rule of thumb, the product of P/E ratio and price-to-book should not be more than 22.5 (P/E ratio of 15 x price-to-book value of 1.5). The 15 P/E was a result of Graham wanting his portfolio to have a yield equal yield to that of a AA bond (back then around 7.5%). The inverse of this yield is 1 divided by 7.5%. That works out to 13.3; he rounded up to 15.

Select Dividend Stock's Fair ValueI am currently weighting the Mid-2 price and NPV MMA price by taking the lessor of the two + lower of 1.) 30% increase or 2.) 75% of the difference between Mid-2 price and NPV MMA price. Below are several select stocks with along with their calculated Fair Value Price and % discount:

Walgreen Co. (WAG) | Yield: 1.6% Fair Value: $44.41 | % Discount: 0.8% Walgreen Co is the largest U.S. retail drug chain in terms of revenues. It operates more than 8,000 drug stores throughout the U.S. and Puerto Rico.

The Clorox Company (CLX) | Yield: 3.2% Fair Value: $74.92 | % Discount: 9.1% The Clorox Company is a diversified producer of household cleaning, grocery, and specialty food products is also a leading producer of natural personal care products.

Lockheed Martin Corp. (LMT) | Yield: 3.7% Fair Value: $93.50 | % Discount: 13.9% Lockheed Martin Corp. is the world's largest military weapons manufacturer and is also a significant supplier to NASA and other non-defense government agencies receiving about 93% of its revenues from global defense sales.